Insights and Opinions

Tax Extenders Bill Will Stifle Innovation In the US

We are concerned in the venture capital community by the bill known as the "Tax Extenders Bill", which was passed in the House of Representatives last week. The provision on changing the tax treatment of "carried interest" was thrown in at the last moment to offset the loss of revenues that results from extending some tax benefits to corporations into 2010. This changes the tax structure for carried interest from capital gains to ordinary income for the general partners of venture capital firms (and private equity firms too), on the gains that they realize from their investments. Frequently, the "carried interest" runs at 20% of the profits from an investment are allocated to the general partners of a fund (although offset by the appropriate similar level of losses that occur in other parts of the portfolio). It adversely penalizes general partners of venture capital firms, who assume much of the same high risk as entrepreneurs from spending considerable time and effort in trying to help make nascent start-ups become successful.

In my view, if the Senate Finance Committee does not pull this provision out of the Bill before a vote by the Senate, these proposed changes will have a significant effect on stifling innovation in the United States, which will lead to reduced opportunities, job creation, and prosperity in our nation as a whole. Many of the great companies created by venture capital were funded at a very early-stage with relatively little equity. This is true of Apple, Cisco, Google, Yahoo, Oracle, eBay, Microsoft, VMware, and Adobe to mention but a few, where the venture capitalist had expended time, like the "sweat equity" of the entrepreneur who receives very cheap founders’ stock, and yet who upon sale of shares will have the benefit of capital gains tax treatment. The effect of passing this legislation is one more nail in the coffin of technological innovation and job creation in this country, in that the natural tendency will be for venture capitalists to invest more only in "safe", later-stage investments because one is effectively being taxed at ordinary income tax rates at whatever one invests in. Why take the early-stage risk with the entrepreneur if the tax treatment is to be so divergent from that of entrepreneur? Furthermore, the talent pool of venture capitalists, which have helped create with their skills some of the greatest U.S. corporations will most likely be significantly weakened by this disincentive to be part of our industry vis-ŕ-vis other alternatives.

We share in the successful high risk investments alongside the entrepreneurs when we invest dollars from our venture capital funds. Tremendous expansions in job creation have occurred when these companies hit their stride. Without venture capital investments, we stand to lose the fuel which will drive the next wave of innovative companies that will serve as an important foundation of our US economy.

There are no other institutional sources of capital which will seek to invest in these highly risky endeavors. The venture capital industry is a uniquely successful U.S. phenomenon, but other countries, such as China, are making great strides to emulate our success and with tax treatments far more favorable to the venture capitalist general partner.

As we consider introducing additional taxes on those making the allocation of high risk venture capital dollars work, we risk stifling the core innovation engine which helps drive an important element of the economy of our nation. Once again the law of unintended consequences will be operational if this Bill is passed as is, without addressing the likely harm to the venture capital industry.